Monday, October 22, 2007

Big Gap Down After a Big Down Day: What Comes Next?

My historical studies typically take the most distinctive aspects of the present market and then ask, "When this has occurred in the recent past, what has typically followed in the markets?" As it looks right now, the S&P 500 Index (SPY) looks set to gap open much lower following a very weak day on Friday. What has typically occurred when a large gap to the downside has followed a big down day?

I went back to 1996 (N = 2934 trading days) and found 26 occasions in which SPY was down by more than 2% the prior day and then gapped open to the downside by -.5% or more. From the downside gap open to the close of that same day, the market was up 15 times, down 11, for an average gain of .86%. The following day (from the close of the gap down day to the close of the next day), the market was up 18 times, down 8, for an average gain of 1.18%. All in all, from the downside gap open to the close of the following day, the market was up 20 times, down 6.

In short, there has been no bearish edge to selling into a sizable gap down when the prior day has been down sharply. Indeed, on average, the trader would have made money by buying the open and holding through the following day.

While that's not a pattern I'll be trading mechanically, it is one that primes me to look for buying setups during the day--especially price lows that are accompanied by fewer stocks making new lows and less extreme negative TICK readings. Should we not get those setups, that too would be an important indication, as it would suggest that the market is so weak that it cannot live up to historical precedent.

About Me

Author of The Psychology of Trading (Wiley, 2003), Enhancing Trader Performance (Wiley, 2006), and The Daily Trading Coach (Wiley, 2009) with an interest in using historical patterns in markets to find a trading edge. I am also interested in performance enhancement among traders, drawing upon research from expert performers in various fields. I took a leave from blogging starting May, 2010 due to my role at a global macro hedge fund. Blogging resumed in February, 2014, along with regular posting to Twitter and StockTwits (@steenbab).